Let's Spot A High Yield Bubble!

The Times and the Journal today are pretty excited by the new high yield bubble and I guess? What is the deal with high-yield yields being not as high as high-yield yields have been in the past, yield-wise? The answer may be giddiness:*

“In a yield-starved world, high-yield bonds are right now the only game in town,” said Les Levi, a managing director at the investment bank North Sea Partners. “The market is giddy.”

The $700 million bond Nuance Communications sold last week looks like a textbook high yield deal, except it doesn’t have the yield. ... Underwriter Barclays managed to squeeze 5.375% yield out of the fund managers who bought the eight-year deal. That’s almost half the 9.55% average of Barclays US Corporate high yield index since 2002 and is right above the 5.1% average yield of the bank’s investment grade bond index over the same time period. The average interest rate – or coupon – on new junk bonds over the past 30 years has been 11%, according to Thomson Reuters. ...

But the top determinant of high yield bond performance, the default rate, is headed the other way. The trailing twelve-month default rate rose to 2.7% in July from 2% at the end of 2011, according to Standard & Poor’s. The rating agency expects defaults to hit 3.7% by this time next year, within hailing distance of the 4.5% 30-year average for speculative-grade bonds.

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Because I was bored I went and modeled that Nuance deal in a stupid way. Here is my model. The key assumption is the default rate**: if you assume that Nuance's probability of default is 2.7% a year over the next 8 years, then this bond is worth about 106 cents on the dollar and not bubbly at all; if you assume 3.7% then it's worth 99 cents on the dollar and so is fair-ish; and if you assume 4.5% then it's worth about 93 cents on the dollar and you should stay the heck away.

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What should you assume? Well, that Journal article gives you those three data points, with 4.5% being the long-term average for junk bonds and 2.7% being the current run rate, but remember that Nuance's bond is rated Ba3/BB- so it should do a bit better than that. S&P has a more nuanced (HA!) transition matrix here; over the last 30 years about 1.3% of BB- bonds have defaulted within twelve months (though another 13% or so have moved to lower ratings).*** At a 1.3% annual probability of default, this Nuance bond is a steal, worth almost 117 cents on the dollar.

Obviously I am not going to go around predicting the future of junk bonds. I don't need that kind of risk; all my money is safely tucked away in Great Idea Corp. And obviously there is much going on in the world besides default risk - FT Alphaville the other day put up this note from Citi arguing that ~100% of the BBB spread to Treasuries is due to macro factors and ~0% is due to default risk which, what?, okay:

DealBook gives the last word to Les Levi of the giddiness worries, saying "This could pave the way for some heartbreak down the road." Sure, why not. One thing to think about the Great High-Yield Bubble of 2012 is that it doesn't look like a bubble in high-yield bonds. That Nuance bond is trading at around 101.5 today, per Bloomberg, which implies on my dopey math an expected annual default probability of 3.3% - two percentage points above S&P historical BB- default rates.**** That does not sound like a market that is totally blind to the risks of high-yield issuers, or that has put a lot of faith in this-time-is-different-ness. Rather, it sounds like a market that is just really really used to low (risk-free) interest rates and expects them to continue for quite a while. Which they probably will. But if there is heartbreak to come, that's where it'll probably come from.

The record-low yields in the junk bond market are a function of several factors.

First, they reflect the low-interest rate world that has persisted since the crisis. Treasuries are the benchmark for pricing high-yield bonds. Investors receive a higher interest rate for junk bonds, a so-called spread over Treasuries, because the risk of default is higher. And since interest rates on government bonds are so low — the 10-year Treasury is paying a paltry 1.8 percent — companies do not have to pay as much on their bonds.

Yields on junk bonds have also declined because the price of a bond moves inversely to its yield. So as junk bond prices have appreciated, yields have dropped. The return on a bond is made up of its interest rate and price appreciation.

What would you do if your analyst said this to you?

You: Why are junk bond yields down?

Analyst: Because prices have gone up, and prices move inversely to yields.

I feel like in his first week on the job I’d be nice (“Okay, great, well put. Now: why have prices gone up?”). After that, not so much.

** Another key assumption is the risk-free rate used to discount the default-risked cash flows. You don't have to trouble your pretty little head about it in the model, since I'm using Libor swap rates pulled from Bloomberg this afternoon. But, of course: why would you discount at Libor? Anyway. Your life will not change dramatically if you discount some other way.

Also big: I sort of assumed zero recovery on default, why not. If you throw in a market-standard 40% recovery these bonds start to look great.

*** Here is the matrix; read across from any rating to see what % of bonds with that rating were at whatever other rating within 12 months. D is default:

You could of course build a much better model than mine using these matrices - my model implicitly assumes BB- or whatever forever with a potential jump to default each year, which is dumb - BUT THEN: if you wanted to do that you probably already have a better model and don't mess around with Google Docs, so.

**** Or like 5.3% implied default rate if you assume 40% recovery on default.

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: